In: Economics
Explain how to forecast the long -run exchange rate based on the Monetary Approach.
The monetary approach happens to be one of the oldest approaches
to determine the exchange rate. It is also use as a yardstick to
compare the other approaches to determine exchange rate. The
monetary model assumes a simple demand for money curve. The
purchasing power parity or the law of one price holds true. The
monetary model also assumes a vertical aggregate supply curve. A
vertical aggregate supply curve does not imply constancy in the
output but a flexible price.
According to the absolute purchasing power parity the exchange
rate is obtained by dividing the price level of the home country
with that of the foreign country.i.e. P = eP*, P stands for the
domestic price level and P* the foreign price level. e is the
exchange rate.
At this point external equilibrium is obtained in the economy. It
is also clear fro the above equation that an increase in the money
supply within an economy would lead to appreciation of the domestic
currency. Conversely, international price level a well as the
output level related inversely with the exchange rate.
Let us consider a situation where keeping all parameters fixed
money supply rises in the domestic economy. Since prices are kept
constant, excess money supply injects higher demand for goods and
services within the economy. In the face of a fixed output, prices
are pushed up. This will be accompanied by depreciation in the
nominal exchange rate.
In the above discussion we have explained the determination of
exchange rates under a flexible regime. In a fixed regime the
economy takes a somewhat different course.
Let us say that the foreign price level has increased, ceteres
paribus. There is also excess demand for goods that are produced in
the home market. This in turn causes a balance of payment surplus.
Foreign exchange reserves will rise along with an increase in the
money supply. The rise in the supply of money would lead to a rise
in the domestic price level and competitiveness in the economy will
be as before.